How Russia's conflict with Ukraine threatens vital European trade links

Three years ago, Russia declared itself open for business. The situation looks
very different now

It was supposed to be the dawn of a new era. In 2011, Dmitry Medvedev, then president of Russia, was preparing to deliver a keynote speech to the World Economic Forum in Davos.

Russia was “open for business”, he would declare, listing 10 reasons why investors should flock to the former Communist state.

But things have never been smooth for the Russian Bear, and just days before Medvedev was due to deliver his speech, headlines about his appearance in Davos quickly transformed to news that a terrorist bomb in Moscow had rocked Russia’s busiest airport and killed 37 people.

Three years later, Medvedev has been replaced by Vladimir Putin, but the world’s eighth largest economy is still in the headlines for controversial reasons. Tensions with Ukraine threaten to tear apart the smaller nation, with Crimea, located in the south-east of the country, due to hold a referendum next week to decide whether it wants to join Russia.

Phrases such as “Cold War” and “Iron Curtain” have been resurrected, parties have stopped talking and the stand-off is escalating by the day. Last week, the European Union voted in favour of sanctions on Russia. It froze talks on easing visa barriers and threatened economic reprisals if Russia escalated its intervention. Russia launched its own threats in return.

It may seem like a familiar pattern, but as Medvedev’s 2011 speech showed, Russia has worked hard to attract foreign investment in the past. Putin’s first term as president between 2000 and 2004 saw him embark on a charm offensive, wooing world leaders from Tony Blair to George W Bush.

It was not until the 2004 Orange Revolution in Ukraine that relations began to sour. Putin blamed the civil unrest on Western influence, but the deaths of Alexander Litvinenko, a fugitive officer of the Russian FSB secret service, in 2006, and Sergei Magnitsky, a Russian accountant, in 2009, have only made a strained relationship more difficult.

But while political tensions run high, doing business in Russia is now much more attractive. Today, Russia is the world’s largest exporter of energy and one of Britain’s biggest markets outside the EU. According to HMRC, the UK exported £3.9bn of goods to Russia in 2013 – a value that has almost tripled over the past decade – while imports totalled £6.8bn.

The UK imports thousands of tonnes of commodities each year from Russia only to ship much of it back in the form of cars, machines and other vehicles – helping to feed Russia’s insatiable appetite for luxury goods.

Trade has also blossomed with the EU. Russia is its third largest trading partner, while the 28-nation bloc is Russia’s biggest customer. Energy forms 80pc of the EU’s imports from Russia, and some argue this has weakened the EU’s hand when it comes to further sanctions.

Germany – Europe’s biggest economy – relies on Russia for half its oil and 40pc of gas, half of which passes through Ukraine. By comparison, the UK buys about 6pc of its gas from Russia. The possible consequences of sanctions on the Baltic states, Finland, the Czech Republic, Slovakia and Bulgaria are even greater, as these countries are 100pc dependent on gas from Russia’s state-owned energy giant, Gazprom.

“There aren’t a lot of effective ways to restrain Russia,” says Francisco Blanch, a commodities strategist at Bank of America Merrill Lynch. “If you implemented sanctions similar to those on Iran, it would be like shooting yourself in the foot. The Brent [oil] price is almost $110 a barrel. If you impose sanctions on Russia, you’re going to send the energy price through the roof and countries will slip into recession.

“[The relationship] is a symbiotic one – [Russia and the EU] both need each other, and they know it. It’s not like the EU can sanction Russia and hurt it without hurting itself. And vice versa.”

Others suggest Russia has much more to lose from a trade war. Sir Roderic Lyne, deputy chairman of Chatham House and a former British ambassador to Russia, said it would be much easier for countries such as Germany to source gas from elsewhere than it would be for Russia to find a new buyer.

“Russia can’t afford to lose one of their biggest export markets for their biggest export commodity,” he says. “Occasionally countries cut off their nose to spite their face. But while it sounds like a powerful threat, when you look at it closely, the leverage is almost the other way around.

“People in Europe tend to get into a panic about Russia cutting off our gas supply as if all the lights will go out. What they forget is it’s worse for Russia than it is for us.” Blanch agrees that Russia’s trade dependence on commodities puts it at a disadvantage.

“Economically, Russia is a very imbalanced country with a lot of oil and gas, a very big consumer market that uses these revenues to consume goods domestically. But Russia doesn’t make a lot of things and doesn’t really sell a lot else.

“If Russia cut off energy exports to Europe, Russia’s reputation as an exporter of energy would be decimated.” Closer ties between Britain, the EU and Russia also mean there’s more to this high-stakes economic poker game than just energy.

BP now owns almost a fifth of Russia’s Rosneft. With a significant proportion of BP’s dividend payments paid into UK pension funds, Russian turmoil has wider implications for Britain.

Russia also has a prominent presence on the UK stock market. More than 60 companies originating from the former Soviet Union have listed in London in recent years. The Steel maker Evraz – part-owned by Chelsea football club owner Roman Abramovich – illustrates how deep financial links have become, while Lenta, the St Petersburg-based hypermarket group, is one of the most recent newcomers on the London Stock Exchange.

Ultimately, Sir Roderic says it’s in no one’s interest to rock the boat. “Of course Britain doesn’t want [tensions to escalate], because it would be disruptive to the financial system, and it would cost the City of London.” Less state interference also means Russian businesses are no longer subject to political whims, and many Russians boost UK growth via tourism and property purchases.

“During the Cold War, relations between governments almost dictated the whole relationship,” says Sir Roderic. “That’s absolutely not the case now because we connect with Russia and Russians on many different levels. When I was ambassador in Moscow, we passed the 100,000 mark for the number of visas issued to Russian visitors coming to the UK. Last year, the official figure was 226,000. Twice as many Russians are coming here to connect with British people, and they’re not just government officials.”

For many Russians, it will remain business as usual. Oleg Mukhamedshin, the deputy chief executive of Rusal, the world’s largest aluminium producer, says the weak rouble caused by outflows in emerging markets has been good for business.

“I don’t see any specific negative impact from this Ukrainian situation on our business so far,” he says. “As an exporter, we’re obviously interested in a balanced currency exchange rate and obviously the rouble was quite overvalued for a certain period of time.”

Mukhamedshin also believes Europe’s nascent recovery could be pushed off course if tensions escalate. “We see some slight recovery in Europe, for example aluminium consumption last year has increased in Europe, which is a good signal, so you would[n’t want to] put this recovery under risk.”

The other fear is that in times of crisis, co-operation and co-ordination is replaced by selfishness and nationalism. In an EU with 28 members, the potential for squabbling is huge.

Pawel Swidlicki, a research analyst at Open Europe, says many countries in Eastern Europe still carry the scars of the past. “Poland is one of the more hawkish countries [when it comes to Russian sanctions]. It wants to go quite hard on Russia, whereas the rest of the EU – particularly Germany – are much more cautious,” he says.

“The stakes are a lot higher for Poland and the other central eastern European countries because this brings back very bad memories of Russian domination. To them, if you give Russia an inch they’ll take a mile.”

While the EU and US ponder their next steps, it seems Putin’s predecessor had some wise words in 2011. Back then, Medvedev told business leaders and politicians at Davos that diversity and coexistence was the key to success.

“A single-format world is full of risk [while] a multi-format world is capable of compensating for such risks and provides an opportunity to adapt to new challenges,” he said. Both the EU and Russia would be wise to heed those words.